With the SEC now deciding what to do about so-called “dark pools” of liquidity, we thought this would be an excellent opportunity to explain what exactly goes down.
First and foremost, what is a dark pool? In essence, it is a network of firms or a single firm or exchange that provides liquidity for traders who want to move a large number or block order of shares without showing their hand — similar to that of a poker player.
An individual investor need not concern his or herself with accessing this liquidity, as it is simply not useful for them. But institutional investors and investment banks will use dark pools to silently move markets without alerting anyone. Think about it for a second: if you, the institutional investor, tried selling 2 million shares of Company XYZ on NASDAQ, it’d be huge news and the information would hit the public eye instantaneously. But in a dark pool exchange, like SmartPool or Liquidnet, you can make your trade behind closed doors, whether you are buying or selling.
In respect to large block trades, these dark pools of liquidity can allow an investor to get the price they want for all or nearly all of the shares. In a regular exchange, you’d have to break it up into smaller blocks and depending on market conditions, you can risk losing out on your profit.
Why the brouhaha over these dark pools? The SEC must be going after them for one reason or another, right? The answer is transparency. The SEC feels that the general public and smaller investors are being hurt by these pools that allow others to trade in secret without disclosing information. A valid point, but that’s one of the major reasons dark pools exist. And if we visit the block trade aspect of all this again, the SEC wants to limit the number of shares one can trade in a dark pool, thus reducing the ability of bigger investors to make very large trades.
Ironically, dark pools are an antidote to Flash and High-Frequency Trading, which are also under regulators watchful eye.
The best way to understand dark pools is to break it down to its absolute basics and no one does that better than Marketplace Senior Editor, Paddy Hirsch. In the video below, Hirsch, armed with his trusty whiteboard, carefully draws out the actions of what happens within these dark exchanges. The language is simple and understandable and the drawings are quite humorous. For a summary on how it works, we highly recommend watching his explanation:
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